ADVANCING EXEMPLARY BOARD LEADERSHIP

The Realities of Pay-for-Performance Alignment in 2014 Compensation Series

August 7, 2014

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Meet The Presenters

Ryan Compaan

Vice President, Pearl Meyer & Partners

Martin Coyne (moderator)

Director, Akamai and RockTech

Simon Patterson

Managing Director, Patterson Associates, a Pearl Meyer & Partners

Practice

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Housekeeping

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Housekeeping

Click below for a copy of the slides.

Slides are also available at pearlmeyer.com/PFPUKUS

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You will automatically receive 1 NACD skill-specific

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Credit may be applied to NACD Fellowship

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The replay and slides will also be available early

next week at NACDonline.org/webinars and

pearlmeyer.com

Housekeeping

Pay for performance in the news In the UK

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Barclays boss Antony Jenkins:

‘We pay for performance’

Gap widens between UK

executive pay and results

Extravagant CEO pay doesn’t reflect

performance – it’s all about status

…and in the US

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‘Pay for Performance’ No Longer a Punchline

Shift Highlights Growing Role of Investors in Shaping Compensation

Pay for Performance? It Depends on the Measuring Stick

Misleading CEO Pay-for-Performance

Numbers Target of SEC

‘Atlantic gap opens in bank chiefs pay’

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“If one banker epitomises the new period of modesty among

European lenders, it is Ross McEwan. Last year, the New

Zealand-born chief executive of Royal Bank of Scotland

received a fifth of an almost $20m pay package earned by

Lloyd Blankfein, his counterpart at Goldman Sachs.”

The New York Times published its

annual league table of chief executive

pay at the US’s top 100 publicly quoted

companies in April.

The average has now climbed to $13.9m (£8.3m)

That is nearly twice the average of £4.4m for CEOs within Britain's top 100

America's top 100 companies however are, on average, around three times

larger in terms of turnover than Britain’s

A KPMG survey found…

• A majority of FTSE 350 companies are paying

CEOs at least 60% of their maximum

allowable bonus

• This comes despite a quarter of companies

reporting a fall in profits.

• One third of companies paid their CEO a bonus of

80% of the maximum value

• Only 10% of FTSE 100 and 7% of FTSE 250

CEOs did not receive a bonus in 2013

9 Source: KPMG’s Guide to Directors’ Remuneration 2013, Nov 2013

Recent studies even ask: is high pay inversely related to performance?

• The US study found excess CEO pay is negatively related to future stock

returns

• Firms that paid their CEOs in the top 10% of “excess pay” earned negative abnormal

returns over the next three years of approximately -8%

• Stock options most negative result

• Hypothesis

• Effect stronger for CEOs who receive high incentive pay relative to peers

• Study suggests overconfident CEOs accept large amounts of incentive pay and

consequently engage in value destroying activities that translate into future reductions

in returns and firm performance

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Source: Performance for pay? The relation between CEO incentive compensation and future stock price performance,

Jan 2013, by MICHAEL J. COOPER, University of Utah, HUSEYIN GULEN, Purdue University, & P. RAGHAVENDRA RAU, University of Cambridge.

Data: Execucomp, S&P1500,1994-2011. ‘Excess incentive pay’ is defined as payment of restricted stock, options and other forms of long-term

compensation in excess of the median pay to peer firms in the same industry and size group.

Does the use of restricted stock, options and long-term incentive payouts

necessarily translate into higher future returns for shareholders? A University

of Utah study thinks not...

US Proxy Season Trends

• 2014 Say on Pay results were very similar to 2013:

• Continued scrutiny of “red flag” pay practices:

• Lack of alignment between performance and pay

• CIC Excise Tax Gross ups

• Single-trigger equity vesting

• Increasing focus on pay-performance relationships:

• Emphasis on performance share plans (vs. restricted stock or stock options)

• Gradual reduction in max payouts (200% 150% 125%; more prevalent in

some regulated industries [e.g., banking])

• Scrutiny of disclosure of the difficulty of performance goals

• Review of rTSR plans under negative TSR situations

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% “passing” Average “for” Failures

2014 98.1% 90.3% 55 (1.9%)

2013 97.9% 91.2% 56 (2.1%)

Key Themes and Emerging Issues

In both the UK and US, “Pay-for-Performance” is ubiquitous. Almost all

companies espouse a pay for performance philosophy.

Most companies are now able to demonstrate that pay is aligned with

performance.

However, the next generation of P4P is addressing more difficult issues:

• Are we paying for the right performance?

• Are we paying for the right amount of performance?

• Are we delivering the right amount of pay for the right amount of

performance?

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How should performance be defined?

Performance can be defined using numerous measures, against various

standards, and over an infinite number of time periods

Performance evaluation is highly dependent upon context, and can be:

• Financial

• Strategic

• Operational

• Qualitative or quantitative

• Measured in shareholder returns

• Evaluated relative to absolute goals or relative to peers or an index

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Key stakeholders define performance using different measures, standards and time frames

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Stakeholder Measure Standard Timeframe

Wall St. Analysts/

Institutional

Investors

EPS Consensus

expectations

Quarterly/

Annual

Institutional

Shareholder

Services (ISS)

Total Shareholder

Return (TSR)

ISS peer group Three years

(also 5-yr for

Pay-TSR test)

Company

Employees

Key operating measures

(product quality, volume,

customer retention, etc.)

Prior year

and/or internal

budget goals

Annual

PM&P TSR + relevant financial

measures

Peer group 1-year, 3-year

and 5-year

UK CEO Value

Index

Shareholder Value

Added

Index or Peers 4 years

UK CEO Value Index measures performance based on value added to shareholders

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Total value added to shareholders is calculated as:

This measures performance from a shareholder perspective

Change in

share price Dividends paid

Share

buybacks

Total value

added to

shareholders

CEO Value Index Value Added over 4 years

Total Direct Compensation over 4

years

=

The UK CEO Value Index is a simple ‘rule-of-thumb’ to guide remuneration

decision-making. The Index calculates the value added to shareholders

per pound of compensation paid to the CEO over a four year period

UK CEO Value Index FTSE 100 Total Value Added vs. Total Remuneration

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R² = 0.1785

£0

£5,000,000

£10,000,000

£15,000,000

£20,000,000

£25,000,000

£30,000,000

£35,000,000

£40,000,000

-£10,000 £0 £10,000 £20,000 £30,000 £40,000 £50,000 £60,000 £70,000 £80,000

To

tal R

em

un

era

tio

n

Total Value Added (millions)

Total Value Added vs. Total Remuneration FTSE 100, 2009 to 2013

There are a number of companies who

continue to pay a significant amount

for minimal performance

Just 10% of FTSE 350 companies achieved Indexes above £1,000

• Analysed 243 companies out of the FTSE 350 (including 7 that lost value)

• Companies ranked by their Index score

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No. companies Index score range Median Index score

Top 10% 24 above £1,000 £1,735

Middle 10% 24 £186 to £246 £205

Bottom 10% 24 £31*

* Of those that added value

£0

£1,000

£2,000

£3,000

£4,000

£5,000

£6,000

£7,000

£8,000

0 50 100 150 200 250

UK

CE

O V

alu

e I

nd

ex

Ranking

UK CEO Value Index Rankings

Value added

Value lost

To

p

10%

Mid

dle

10%

Bo

tto

m

10%

LTI payouts are greatest for top performers

• Top 10% have the highest salary, bonus and LTI payments

• Median salary: higher for the bottom 10% than the middle 10%

• Middle 10% typically twice the market cap of the bottom 10%

• Size and pay relationship has broken down here

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Top Middle Bottom Top Middle Bottom Top Middle Bottom

Upper Quartile £4,582,000 £2,482,842 £2,985,250 £4,037,583 £2,473,501 £2,675,750 £7,441,027 £2,888,699 £731,066

Median £4,049,299 £2,027,000 £2,580,000 £2,736,264 £1,550,000 £1,246,859 £2,151,707 £1,535,283 £331,986

Lower Quartile £3,612,000 £1,669,608 £1,905,750 £900,058 £756,800 £696,488 £0 £361,236 £0

£0

£1,000,000

£2,000,000

£3,000,000

£4,000,000

£5,000,000

£6,000,000

£7,000,000

£8,000,000

Remuneration breakdown for Top, Middle & Bottom ranked Index performers

Salary Bonus LTI

Upper quartile

Median

Lower quartile

Things to remember

• The pay governance debate is global, and the US can learn from

experience internationally

• Much of the world has settled on Total Shareholder Returns (TSR) as a

measure with which to calibrate pay, but a single measure of performance

may not be sufficient for a robust pay-for-performance relationship.

• Framing CEO pay in the context of overall value created allows more

meaningful discussions of pay philosophy and incentive design

• Analysis of pay relative to value of peers helps provide additional insights

into reasonableness of CEO pay...

• ...as does prospective testing. What does a ‘market’ pay package require in

terms of incremental value, to be justified?

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So what should Compensation Committees do differently?

• Ensure incentive programs are designed to support unique company

business strategy, not necessarily what is prevalent or “best practice”

• Disclose the “why’s” in addition to the “what’s”

• Understand how your CEO pay compares to everything, to anticipate potential issues

• Invest additional time in discussions of “performance” in Pay-for-

Performance relationships

• Focus on right measure of performance

• Focus on degree of difficulty of performance goals and calibration of payouts

• Proactively respond to potential threats to stronger alignment of pay and

performance

• CEO pay ratio disclosure may be catalyst for deleveraging executive incentive

programs

• Modifiers to LTI programs for “negative TSR” situations may disrupt strong pay-for-

performance relationships

• Caps on LTI payouts – particularly in regulated industries – skew P4P relationships 20

ADVANCING EXEMPLARY BOARD LEADERSHIP

Questions

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November 18, 2014

2:00 pm ET

Compliance & Communication: The Dynamic Duo of Disclosure

To register or check out the archives of earlier webinars in this series, visit NACDonline.org/webinars.

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